The present subject matter relates generally to a method for creating an index exchange-traded fund using a convertible unit investment trust. More specifically, the present invention relates to incubating an exchange-traded fund with a convertible Unit Investment Trust that converts to the exchange-traded fund upon meeting a predetermined conversion benchmarks.
A “unit investment trust,” commonly referred to as a “UIT,” is a type of investment company. Generally, an “investment company” is a company (corporation, business trust, partnership, or limited liability company) that issues securities and is primarily engaged in the business of investing in securities. An investment company invests the money it receives from investors on a collective basis, and each investor shares in the profits and losses in proportion to the investor's interest in the investment company. The performance of the investment company will be based on, but not necessarily identical to, the performance of the securities and other assets that the investment company owns. Two other types of common investment companies are mutual funds and closed-end funds.
UITs have traditional and distinguishing characteristics. A UIT typically issues redeemable securities (or “units”), like a mutual fund, which means that the UIT will buy back an investor's “units,” at the investor's request, at their approximate net asset value (or NAV). Some exchange-traded funds (ETFs) are structured as UITs. Under SEC exemptive orders, shares of ETFs are redeemable in very large blocks (blocks of 50,000 shares, for example) and are traded on a secondary market. Typically a UIT will make a one-time “public offering” of a specific, fixed number of units (like closed-end funds). Many UIT sponsors will maintain a secondary market, which allows owners of the UIT units to sell them back to the sponsors and allow other investors to buy these UIT units from the sponsors. A UIT will have a termination date (a date when the UIT will terminate and dissolve, also referred to a maturity date) that is established when the UIT is created (although some may terminate more than fifty years after they are created). In the case of a UIT investing in bonds, for example, the termination date may be determined by the maturity date of the bond investments. When a UIT terminates, any remaining investment portfolio securities are sold and the proceeds are paid to the investors. A UIT does not actively trade its investment portfolio. A UIT buys a relatively fixed portfolio of securities (for example, five, ten, or twenty specific stocks or bonds), and holds them with little or no change for the life of the UIT. Because the investment portfolio of a UIT generally is fixed, investors know more or less what they are investing in for the duration of their investment. Investors will find the portfolio securities held by the UIT listed in its prospectus. Finally, a UIT does not have a board of directors, corporate officers, or an investment adviser to render advice during the life of the trust. Because a UIT had excellent performance last year does not necessarily mean that it will duplicate that performance in the future. For example, market conditions can change, and this year's winning UIT could be next year's loser.
An Exchange Traded Funds (ETF) is a fund that tracks an index like the NASDAQ-100 Index™, S&P 500™, Dow Jones™, etc. When you buy shares of an ETF, you are buying shares of a portfolio or basket that tracks the yield and return of its native index. The main difference between ETFs and other types of index funds is that ETFs don't try to outperform their corresponding index, but simply replicate its performance. ETFs have been in use since the early 1980s.
ETFs combine the range of a diversified portfolio with the simplicity of trading a single stock. Investors can purchase ETF shares on margin, short sell shares, or hold for the long term.
The purpose of an index ETF is to match a particular market index, leading to a fund management style known as passive management. Passive management is the chief distinguishing feature of ETFs, and it brings a number of advantages for investors in index funds. Essentially, passive management means the fund manager makes only minor, periodic adjustments to keep the fund in line with its index. This is quite different from an actively managed fund where the manager continually trades assets in an effort to outperform the market. Because they are tied to a particular index, ETFs tend to cover a discrete number of stocks, as opposed to a mutual fund whose scope of investment is subject to continual change. For these reasons, ETFs mitigate the element of “managerial risk” that can make choosing the right fund difficult.
Because an ETF tracks an index without trying to outperform it, it incurs fewer administrative costs than actively managed portfolios. Typical ETF administrative costs are lower than an actively managed fund, coming in less than 0.20% per annum, as opposed to the over 1% yearly cost of some mutual funds. Because they incur low management and sponsor fees, and because they don't typically carry high sales loads, there are fewer recurring costs to diminish returns.
Passive management is also an advantage in terms of tax efficiency. ETFs are less likely than actively managed portfolios to experience the trading of securities, which can create potentially high capital gains distributions. Fewer trades into and out of the trust mean fewer taxable distributions, and a more efficient overall return on investment. Efficiency is one reason ETFs have become a favored vehicle for multiple investment strategies—because lower administrative costs and lower capital gains taxes put a greater share of your investment dollar to work for you in the market.
ETF shares trade exactly like stocks. Unlike index mutual funds or UITs, which are priced only after market closings, ETFs are priced and traded continuously throughout the trading day. They can be bought on margin, sold short or held for the long-term, exactly like common stock. Yet because their value is based on an underlying index, ETFs enjoy the additional benefits of broader diversification than shares in single companies, as well as what many investors perceive as the greater flexibility that goes with investing in entire markets, sectors, regions, or asset types. Because they represent baskets of stocks, ETFs typically trade at much higher volumes than individual stocks. High trading volumes mean high liquidity, enabling investors to get into and out of investment positions with minimum risk and expense.
One major drawback to an ETF is the cost, risk, and complexity of bringing an ETF to market. Accordingly, there is a need for systems and methods for reducing the cost, risk, and complexity of bringing an ETF to market.
Accordingly, there is a need for systems and method for creating an index exchange-traded fund using a convertible unit investment trust, as described herein.